Theory of the firm

• Characteristics of perfect competition: Firms are price takers, no barriers to entry or exit, homogenous (no differentiation), no monopoly power, perfect buyers + sellers knowledge, perfect factor mobility, firms are profit maximisers.
• Characteristics of a monopoly market: Firms have a large market share, barriers to entry are high, and firms can set prices as they wish, no close substitutes, relatively price inelastic PED.
• If a monopoly is to remain effective, it must prevent entry of new firms. Monopolists can achieve this by:

  • Ownership of raw materials e.g nickel in the Rockies. Diamonds in South Africa.
  • Legal barriers may prevent firms making commodities. Statue may give only one firm permission to provide a good e.g severn Trent water ( Natural monopoly )
  • Technical and financial barriers
  • Deliberate action ( Price cutting, taking over bids ect )
• Price discrimination is when a business sets different prices for different customers. Monopolists may do this as they are selling in different markets, markets may be separated in a number of ways:

  Geography

  Time

  Class

  Brand loyalty

  Geography

  Legal distinction

  Snobbery
• Conditions needed for price discrimination:

  • There must be no close substitutes for the commodity ( otherwise it wouldn't be a monopoly )
  • There must be no seepage between the markets, the resale of the commodity must not be possible
  • Price elasticity of demand must be different in the two markets
• Perfect competition achieves Productive efficiency and allocative efficiency.
• Monopolies achieve dynamic efficiency
• Oligopoly is the market situation where an industry is dominated by a few large firms. Characteristics of an oligopoly: Similar products mean firms invest heavily in differentiation and branding of products, small number of firms, Price stability over time is common, Non price competition is common, Price wars are occasional features.
• In an oligopoly dominated by firm A and firm B, if firm A reduced its prices, how would firm B react? ( e.g Pepsi and coke )

  Strategic pricing. Firm B would have to lower its prices too as products from A and B are close substitutes.
• Why is price stability likely to occur in the long run of an oligopoly market?

  Mutual interdependence: the actions of one firm will have an effect on the actions and performance of another firm.
• What does the demand curve look like in an oligopoly?

  Kinked. The top part is elastic, while the lower part is inelastic. Oligopolists theoretically operate at the point the inelastic part meets the elastic.

  
• What will happen if a firm in an oligopoly raises their prices?

  Demand will rapidly fall as rational consumers substitute towards other differentiated products of a competing oligopolist.
• By dropping prices of a product in an oligopoly consumers will substitute towards the cheaper product and thus increase their market share. Usually this is short term. This is known as price wars.
• Tacit collusion - Firms do not communicate but a stable price is reached. Legal

  Explicit collusion - Firms agree to set prices, output ect. Illegal
• Within a cartel each firm has a quota, maintaining the relatively high prices. The profit maximising firm may be incentivised firm may break the cartel agreement and increase production as they are covering cost.
• Why do cartels break down?

  • One member overproduces then the whole cartel is destabilised
  • Actions of regulatory bodies, market authorities
  • New nations/firms emerging
  • Changes in demand e.g OPEC less powerful due to increase in demand of renewables
  • External shocks e.g covid
  • Regulator strength - CMA can impose fines of 10% world turnover and imprison individuals for 10 - 15 years.
• Negatives of collusive behaviour

  • Regressive impact on lower income groups
  • Reduced consumer surplus
  • Reduced consumer choice
  • Output reduced means not allocatively efficient
  • Possible consumer exploitation
  • Barriers to entry reduce competition
  • Quotas limit firms expansion, may not achieve EOS
• Positives of collusion

  • Increased profits may cause an increased innovation = dynamic efficiency
  • Sharing information can improve standards over the whole industry eg covid pharma companies
  • Product innovation
  • Increased profit, firm stability
  • Reduction in price volatility